Are iPhone subsidies destroying carriers?

A few weeks ago, T-Mobile’s Chief Marketing Officer Cole Brodman made a rather bold statement: If he could wave a magic wand over the entire mobile industry, he would eliminate carrier subsidies of devices.

His reasoning was simple: by subsidizing the cost of a device over the length of a typical two-year mobile contract, the real cost of smartphones and other mobile devices is essentially being hidden from consumers. The subsidies might make smartphones seem like they have a $200 price tag — and everyone knows AT&T is doing great business with it’s “free” iPhone 3GS — but the real costs of devices are higher, and packed into the required two-year contracts. Brodman laments that these subsidies devalue the technology, and create a “disposal marketplace” where folks are willing to junk “pretty amazing products” after two years (or a year… or even just a few months) in order to keep up with the latest and greatest. If consumers paid the real cost of the devices, they might be more willing to wring more value from them, instead of throwing them away.

It’s notable that these comments come from T-Mobile, which is the only major U.S. mobile carrier that does not offer the iPhone. T-Mobile USA president and CEO Philipp Humm flat-out admitted that “not carrying the iPhone led to a significant increase in contract deactivations in the fourth quarter of 2011.” Is a plea to end subsidies just sour grapes? Or is the high cost of the iPhone really a problem for carriers?

How much does the iPhone cost?

Since the iPhone’s introduction in 2007, Apple has always charged a premium for the device. In fact, Apple’s first agreement with AT&T had the carrier paying Apple every month for every iPhone in use. The companies have since renegotiated, and iPhones are now available from other carriers, but the cost of the iPhone still remains very high compared to other smartphones on the market.

How high? Apple’s most-recent fiscal results reveal that the average selling price (ASP) for an iPhone is about $660. Now, that cost is an average across all iPhone models, from the lowly and almost-three-year-old iPhone 3GS to the high-end 64GB version of the iPhone 4S. Apple does not break down sales across its iPhone lines, but it’s relatively safe to assume sales of the iPhone 4S skew towards the lower end of the line, with the $199 8GB version no doubt being the most popular. That means, of the roughly $660 carriers are paying Apple for an iPhone, about $200 is being picked up by the customer directly. That leaves about $440 to be made up by the carrier over the length of a contract.

How do those contracts work out for carriers? Pretty well. As consumers have embraced smartphones, carriers have embraced ratcheting up costs for data services, and any iPhone owner can testify that current iPhone rate plans aren’t cheap.

iPhone contract costs and subsidy impact

Monthly cost

2-year contract cost

After carrier subsidy

AT&T

$60–$140

$1,440–$3,360

$1,000–$2,920

Verizon

$70–$170

$1,680–$4,080

$1,240–$3,640

Sprint

$90–$110

$1,920–$2,640

$1,480–$2,200

To be sure, these are back-of-the-envelope figures: As the newest carrier to offer the iPhone, Sprint may well be paying a higher per-unit cost for devices than Apple’s original launch partner AT&T (even if the carrier did commit to spending a reported $15 to $20 billion on iPhones through 2014). However, the figures reveal that, after carriers have paid off the cost of iPhones, they’re still making anywhere from $1,000 to $3,600+ per iPhone customer over the span of a 24-month contract. And that’s before taking into account charges for additional services (like hotspot capability), extra voice minutes, extra text messages (or, on budget plans, any text messages at all), and any charges for exceeding a data limit. As we all know, those extra charges pretty much translate directly to carrier profit.

It’s true that carriers aren’t sitting on their hands and simply flipping through their Benjamins over the course of those 24-month contracts — they have costs, too. Carriers have to worry about the costs of building out their networks, making sure they have enough capacity to handle all those data-hungry mobile devices they’re selling, acquiring spectrum licenses, and rolling out new gear to support enhanced services like 4G LTE.

How does the iPhone subsidy compare with Android devices?

Look at the prices of unsubsidized iPhone 4S models compared with loosely comparable Android phones reveals a telling difference. The iPhone 4S entry price is $199, but carries a $649 price tag without a contract — a $450 price difference right in line with the figures revealed by Apple’s financials. Ratcheting up the storage on the iPhone doesn’t change that: There’s still a $450 price difference between contract and no-contract versions of the 32GB and 64GB iPhone 4S. On Verizon, the previous-generation 8GB iPhone 4 has a no-contract price of $549, and that’s the same $450 price difference as a new iPhone 4S.

In contrast, similar Android phones like the Motorola Droid Razr and Samsung Galaxy Nexus carry the exact same $649 contract-free cost at Verizon Wireless. The difference is in the up-front cost to the consumer: Both phones are $299 with a two-year contract, $100 more than the Apple iPhone 4S. In rough figures, then, iPhone subsidies cost carriers about $100 more than Android devices over the course of a 24-month contract. Carriers subsidize the iPhone nearly 29 percent more than they do comparable Android phones. Another way of looking at the difference: $4.17 per month over a two-year contract.

Carrier revenues and the data goldmine

Of course, it’s not as if the smartphone business has been stagnant since the launch of the iPhone: Just the opposite. The primary reason carriers are willing to shoulder the additional subsidies of the iPhone is that the device has consistently proven it brings customers on board. Mobile operators with the iPhone have seen consistent, strong growth in the number of customers they have on postpaid subscription plans. Carriers without the iPhone (we’re looking at you, T-Mobile) are seeing postpaid customers flee to other carriers.

Financial results from all four major U.S. carriers show that, in the last two years, all carriers are seeing increases in their average monthly revenue per customer (ARPU). Overall, every customer is worth more money to carriers now than the same customer was two years ago.

Similarly, the amount of money carriers are earning from customers solely on the basis of data services — which primarily drive smartphones, but also power hotspots, tablets, notebook adapters, and other devices — has been steadily increasing in the last two years.

[Note: I wasn’t able to find/extract reliable data for Sprint’s retail data ARPU for the last two years, so I’ve omitted them from the chart.]

Bottom line: Since the smartphone revolution has taken off in the last two years, every carrier is making more money for every postpaid subscriber, and the proportion of that money generated by data services is growing even faster.

The subsidy argument

So — what if we got rid of phone subsidies? Would consumers be any better off if they paid the full cost for their devices up front? The charts above suggest not, at least not in the United States mobile market.

The main reason carriers are seeing their ARPUs increase is consumers’ broad embrace of smartphones and associated data services. If carriers were to sell devices for their real costs, logic seems to dictate carriers could roll out a corresponding decrease in contract costs without impacting their revenue. However, the math just doesn’t work out. If consumers paid $650 up front for a high-end smartphone, that translates to reducing carrier costs by $350 (Android) to $450 (iPhone) over the course of a 24-month contract. That’s basically $14.50 to $18.75 per month. Instead of contracts costing $60 to $170 per month, consumers would be looking at contracts costing (say) $40 to $150 per month. Although there are undoubtedly customers for whom that price difference might make a difference between having a smartphone or not, those are not generally the same consumers who will be willing to shell out $300, $400, or $650 for a phone.

Furthermore, this scenario assumes the same number of people buying smartphones on subsidies today would still buy them tomorrow if subsidies went away. That’s almost certainly not true — many consumers will balk at the full costs of mobile devices. So for carriers to continue to make $1,000 to $3,600+ on every contract phone subscriber, the contract costs for unsubsidized smartphones won’t go down by $14.50 to $18.75. If, say, half today’s smartphone customers don’t want to pay full price for their devices, that means contract costs only come down by $7.50 to $9.38 per month for carriers to (in theory) break even.

In that scenario, the growth of the smartphone business in the United States would be cut roughly in half. That means fewer devices out in the wild, less money for device makers, and that translates directly to a slower pace of innovation. It also translates to a smaller, less vibrant developer community, which translates to fewer apps and less content for mobile devices. It also means less investment in mobile from Wall Street and other investors. If mobile operators can’t show strong adoption of mobile technologies, investors and banks are will be less willing to throw their money behind network upgrades, frequency licenses, and service expansions.

Of course, this is a broad view: It’s too simplistic to look at carrier subsidies as the fuel driving the smartphone revolution. However, subsidies are a very important factor into getting smartphones and other mobile devices into consumers’ hands, which, ultimately, is the driving force behind the mobile revolution. After all, it doesn’t matter how cool a technology is if no one is willing to buy it.